Before getting into the details of bank regulations, I like to explain the “big picture”
model used by bank regulators. This is shown in Figure 15.1. Capital is required to
cover the difference between the expected loss and a “worst case” loss over sometime time
horizon. For example, the time horizon could be one year and the worst case loss could be
the loss that has only a 0.1% chance of being exceeded.
The key developments in bank regulation that need to be explained are a) the 1988
Basel Accord (Basel I); b) the modification to reflect netting in 1995; c) the 1996 amend-
ment that charged capital for market risk, and d) Basel II. In the material presented in the
book, I have tried to give enough details to give students a good feel for the regulations
without giving so many details that the chapter becomes unreadable. There are a number
of numerical examples to illustrate the workings of Basel I and Basel II. I find it useful to
go through these in class.
The presentation of Basel II focuses on the underlying credit risk model, which is the
factor-based Gaussian copula model covered in Chapter 11. A Harvard Business School
case study that can be used in connection with Basel II is “Basel II: Assessing the Default
and Loss Characteristics of Project Finance Loans (A)” (9-203-035).
Solvency II, the new rules for regulating insurance companies has a similar structure
to Basel II/III. The MCR is analogous to the 4.5% equity capital requirement in Basel
III while and SCR is analogous to the 4.5%+2.5% equity capital requirement (i.e., the
requirement including the capital conservation buffer. A difference between insurance
companies and banks is that insurance companies have exposures on both the asset and
liability side of the balance sheet.
Problem 15.19 can be used for class discussion. Problems 15.20 to 15.22 can be used
as hand-in assignments.
Chapter 16: Basel II.5, Basel III, and Other Post-Crisis Changes
This chapter is an update to Chapter 13 of the third edition. It summarizes some of
the important developments in regulation of banks since the 2007 crisis.
Basel II.5 consists of three changes to the rules for calculating market risk capital. The
rules are a) banks are required to calculate a stressed VaR and use it in the determination
of market risk capital b) banks are subject to an incremental risk charge to ensure that
capital requirements are not reduced when exposures are switched from the banking book
to the trading book, and c) banks are required to use a new method for calculating capital
for exposures that depend on credit correlation.
Basel III consists of new rules for calculating capital for credit risk and two liquidity
ratios that must be adhered to. (The rule concerning CVA can be mentioned for complete-
ness but is probably best handled when Chapter 20 is covered.)
In the fourth edition there are more details on the leverage ratio. Also, G-SIBs,
D-SIBS and SIFIs are discussed,
The chapter covers contingent convertible bonds. These work quite differently from
regular convertible bonds. Regular convertible bonds are exercised when the stock price of
the company issuing the bonds is doing well and the bondholders decide that they would
rather hold equity than debt. Contingent convertible bonds are exercised automatically
when a bank’s equity capital is reaches a low trigger relative to regulatory requirements.
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